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Monetary Policy
Regulating Money Supply
1. Discount Rate Changes• Interest rate at which Banks borrow directly from the Fed
• It is only used in an “emergency” (currently 0.75%)
• Fed can simply raise or lower discount rate
2. Open Market Operations (to change MS which moves the federal funds rate)
– Process of buying or selling government bonds to change money supply
– Change in MS alters the federal funds rate (currently 0.0%)
– Federal Funds Rate= rate banks borrow directly from each other at
2-Tools of Monetary Policy
GDP
2 Types of Monetary Policy
• LOOSE Monetary Policy– Goal: to increase the money supply– MS ↑ => Short Term Interest rates ↓ => AD ↑ => GDP ↑
• TIGHT Monetary policy– Goal: to decrease the money supply– MS ↓ =>Short Term Interest rates ↑ => AD ↓ => GDP ↓
PriceLevel
RealGDP
AS1AS1
AD1AD1AD1
GDP
The Money Market
MS
MD
InterestRate
Qty $
The Money Market
Demand for money is downward sloping as interest rates ↓ more $ is demanded
Supply of Money is fixed by the Fed
Fed “controls” money supply throughmonetary policy
Model of the federal funds interest rate
Monetary Policy Worksheet
• Graphing both MS & AD/AS
6
• Step #1: Lower the discount rate
• Step #2: Use Open Market Operations to increase money supply--the Fed Buys government bonds
Federal Reserv
e
Government bonds
Money supply ↑
Example: Loose Monetary Policy
Solution: Loose Monetary Policy
Affects AD
Inflation
RealGDP
AD1
Economic Situation GDP growth = -1.0%, Unemployment = 10.0%Little to no inflation
AS1MS2
------------------i2 MD
InterestRate
Qty of $
MS1
---------i1AD2
GDPGDP
↓ Discount Rate Buy Bonds => ↑ MS => ↓ Federal Funds Rate
Lower interest rates =>More Loans taken by Consumers & Business C ↑ + I ↑ => so AD ↑
8
• Step #1: Raise the discount rate
• Step #2: Open Market Operations– to DECREASE
money supply Fed SELLS government bonds
Federal Reserv
e
Government bonds
Money supply ↓
Tight Monetary Policy
Solution: Tight Monetary Policy
Affects AD
Inflation
RealGDP
AD2
Economic Situation: GDP growth at +5.0%, Inflation rising, Unemployment 3.0%
AS1MS1
MD
InterestRate
Qty of $
MS2
---------------i1---------i2 AD1
End Result: Lower GDP & less inflation!
GDPGDP
↑ Discount Rate Sell Bonds ↓MS => ↑Federal Funds Rate
Higher interest rates =>Less Loans taken by Consumers & Business C ↓ + I ↓ => so AD ↓
Stimulus Debates• Economists argue over the benefits versus costs of Loose
Monetary Policy
Benefits Costs/Risks
AD1AD1
Inflation
RealGDP
AS1AS1
Federal Reserve in action 1999 - 2012
LooseMonetary Policy
Bernanke Interview #1 (2009)• http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191.shtml?ta
g=mncol;lst;1
AD1AD1
Inflation
RealGDP
AS1AS1
Please watch Part I if you were absent Friday 4/18th
Bernanke Interview #2 (2010)
AD1AD1
Inflation
RealGDP
AS1AS1
http://www.youtube.com/watch?v=LxSv2rnBGA8
Got Quantitative Easing?